Detroit Bankruptcy Reveals 401(k) Virtues

August 20, 2014

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Detroit's Chapter 9 bankruptcy case is scheduled for trial
beginning this Thursday, August 21, when U.S. Bankruptcy Court Judge Steven
Rhodes will decide if the city's restructuring plan is fair, legal and
feasible. Regardless of the outcome, precedents already have been set in the
case that should have public employees elsewhere questioning the wisdom – and
soundness – of their traditional "defined-benefit" pension plans.

Judge Rhodes already ruled, last December, that Detroit's
pension promises are not sacred in a bankruptcy proceeding. Detroit has
subsequently proposed a variety of such cuts to help resolve the estimated
$18-20 billion in debt the city has accumulated. Among those debts is nearly $2
billion in unfunded pension liabilities, owed to city retirees and employees
vested in the General Retirement System. Rather than fully pay pensions for
past work performed, the city is offering to pay 95.5% of promised monthly
pension benefits. The city also wants to eliminate the annual cost-of-living
adjustment (COLA) and have some pensioners pay back millions of dollars in
excessive interest received from 2003 through 2013.

Regardless of the final cuts imposed, the message is clear:
promised city and county pension benefits are no longer sacrosanct, including
those that are fully vested and supposedly guaranteed under state law. This means
that more transparency is needed in public finance, both day-to-day and in
those rare occasions when bankruptcy may be looming.

In the case of Detroit, taxpayers, creditors and current and
former public employees should have insisted that all government-owned assets
be considered during bankruptcy. This did not happen. Valuable city-owned
assets, such as the Detroit Institute of Arts, whose collection was recently
valued as high as $4.6 billion, were excluded from or not fully reflected
in the bankruptcy balance sheet. Fairer recoveries for all creditors would
result if all assets were on the table.

Under the Constitution's Tenth Amendment, which limits the
federal government's power, federal bankruptcy judges cannot order a city or
county to sell assets. But this prohibition doesn't apply to local voters and
government workers, who should have insisted that nonessential government
assets be sold to pay for pension benefits already earned.

The Detroit experience also means that public employees, who
routinely have lobbied for oversized pensions local governments can't afford,
need to realize that defined-benefit pensions may not be such a good deal after
all. Defined-contribution pensions, such as the 401(k) or 403(b), where
retirement benefits are not tied to the long-term financial health of a single
business or local government, may be a better idea. Employees own and control
these accounts, meaning that retirement benefits don't depend on the future
financial health of the local government.

Switching to reasonably priced defined-contribution plans
would not only help employees, it would free up public funds to help finance
unfunded liabilities accrued in the old pension plans. Or the funds could be
spent on schools, police, hospitals, and other basic public services gutted by
rising pension costs.

Local-government employees and retirees should get in front
of this spreading problem and adopt a strategy that keeps them from holding the
bag. Selling nonessential government assets and switching to
defined-contribution pensions would ensure that all earned benefits are paid
and secure retirement systems exist in the future.